Friday, July 13, 2007

After proclaiming himself "satisfied" yesterday with the outcome of initial hearings in Congress on the carried interest tax issue, the Greensboro billionaire and self-proclaimed "world's foremost authority on the proper tax treatment of carried interest" must be less than thrilled with today's developments. Chief among these, of course, was the incendiary page one article in the billionaire-baiting New York Times entitled "Tax Loopholes Sweeten a Deal for Blackstone."

This is just the sort of headline that forces even campaign donation whores Democratic Senators from New York like Chuck Schumer to splutter darkly about "restoring fairness to the tax code." The contents of the article were no less inflammatory, asserting that not only will Steve Schwarzman and his partners recover all of the capital gains taxes they paid on the proceeds of Blackstone's recent IPO, but the government may in fact kick in an additional $200 million as a consolation prize for having given up their private status as founding members of the Star Chamber. I can just imagine how the phone lines into Congressmens' offices lit up this morning as constituents digested that bit of news along with their morning coffee.

Surprising no-one, an unidentified ninja assassin spokesperson for Blackstone dismissed the Times article as "utter codswalloptreasonous bullshit totally flawed." And, to be fair, the article did have its weaknesses. For one thing, it identified the depreciable assets being transferred in the offering as goodwill, whereas in fact they are a combination of existing partnership interests in the underlying portfolio companies' tangible and intangible assets. Established partnership taxation allows partners to deduct their pass-through share of the depreciation and amortization of the assets underlying any partnership. The Section 754 election which Blackstone undertook allows the new partners in the underlying funds to deduct taxes based on the depreciation and amortization of the written-up value of the underlying assets when partnership shares are transferred. The IPO triggered that transfer, since (essentially) the IPO partnership (trading as BX) bought the existing owners' partnership shares with the proceeds of the offering. This ongoing tax shield is valuable to the new partner buying in, to the extent it has current income to offset the deductions.

But the unitholders who bought into the BX offering will enjoy no more than a fraction of the associated tax shield from this election, because prior to the offering Blackstone's partners crafted a "tax receivable agreement" to kick back 85% of the value of this future tax shield to the selling partners in cash. According to the IPO prospectus, this will reduce the future cash flows which public shareholders of BX are entitled to, to a substantial degree:

We expect that as a result of the size of the increases in the tax basis of the tangible and intangible assets of Blackstone Holdings, the payments that we may make under the tax receivable agreement will be substantial. Assuming no material changes in the relevant tax law and that we earn sufficient taxable income to realize the full tax benefit of the increased amortization of our assets, we expect that future payments under the tax receivable agreement in respect of the purchase will aggregate $896.6 million and range from approximately $36.9 million to $80.3 million per year over the next 15 years (or $1,030.4 million and range from approximately $42.4 million to $92.2 million per year over the next 15 years if the underwriters exercise in full their option to purchase additional common units [which did happen]). [p. 209; emphasis mine]

The Times also waved its hands a bit too much in coming up with the $200 million figure as the present value of the net tax benefits available to Little Stevie and his pals under this agreement. To get it, they used the IRS approved discount rate of around 5% on a lump sum payment to come to a total cash value of $751 million, or $198 million more than the 15% capital gains taxes they ascribe to the $3.7 billion gain on sale of the underlying partnership assets. Now, the Times acknowledges that which discount rate to use is a matter of argument, and they cite a hedge fund source which claims a higher rate of 15% (and hence lower net present value) is more appropriate. Further, recapturing this tax shield is not riskless, since it depends entirely on whether BX is able to generate enough income from its ongoing activities to capture the deduction. (The purchasers of the IPO certainly hope so.) Then again, we can probably safely assume that the debtor—the United States Treasury—is good for it. (Or can we?) In any case, it is uncontroversial to say that—almost regardless of discount rate—almost anyone would feel better off if they had a reasonably certain cash flow stream over the next 15 years which totalled over a billion dollars.

Oh, and by the way, the tax receivable agreement between Blackstone's partners and BX requires cash repayments of 85% of the recaptured tax shield for all future exchanges of partnership interests by Blackstone partners for BX units, as well. Given that Blackstone's Senior Managing Directors and "other existing owners" still own 76.4% of the original underlying partnership shares after the IPO, this could amount to a tidy sum of cash for BX to pay out over the next few decades.

Future payments under the tax receivable agreement in respect of subsequent exchanges would be in addition to these amounts and are expected to be substantial. The payments under the tax receivable agreement are not conditioned upon our existing owners' continued ownership of us. [p. 209]

Well, even if BX shares turn out to be a crap investment, I am sure unitholders will take comfort in the fact that they are keeping the Schwarzmans in (almost tax-free) fresh flowers and croque monsieurs.

This little donnybrook will no doubt continue to play out in Congress and elsewhere over the next few days and weeks. It will provide an amusing counterpoint to the specious pontificating about threats to "risk taking" and "competitiveness" and the "attack on wealth" which private equity and its apologists are spewing forth.

Although, come to think of it, there is one area in which the US could indeed suffer a tremendous drop in international competitiveness, should a wholesale rewrite of tax treatment for private equity dramatically simplify the code. We could be at real risk of losing our leading global position in the employment of tax lawyers.